Commercial Bank
The private lender that takes deposits, makes loans and runs the payment system.
Purpose
A commercial bank exists to intermediate between savers and borrowers: it takes deposits that are safe and available on demand and turns them into loans that are risky and long-term. This maturity transformation channels idle savings into productive investment and lets households and firms borrow to buy homes, equipment and inventory. Because deposits circulate as money and lending creates new deposits, banks are also the private engine of money creation and the operators of the payment system through which almost every transaction settles. Their profit comes from the spread between the interest they pay on deposits and earn on loans, net of the losses they must absorb.
Structure — organs & roles
Board & senior management
Sets risk appetite, strategy and capital policy and answers to shareholders and regulators.
Retail & deposit banking
Gathers deposits and serves households with accounts, cards and consumer loans.
Corporate & commercial lending
Underwrites and manages loans to businesses and larger borrowers.
Treasury & asset-liability management
Manages funding, liquidity and interest-rate risk across the balance sheet.
Risk management & credit committee
Sets lending limits, approves large exposures and monitors credit and market risk.
Compliance & operations
Runs payments and settlement and ensures anti-money-laundering and regulatory compliance.
Inputs & Outputs
Inputs
- Customer deposits and wholesale funding.
- Capital from shareholders to absorb losses.
- A banking licence and access to central-bank facilities.
- Credit information on prospective borrowers.
Outputs
- Loans to households, firms and other borrowers.
- Deposit accounts and payment services.
- New money created as loans generate deposits.
- Interest income and profit net of loan losses.
Mandate & Incentives
Mandate
A commercial bank operates under a licence granted and supervised by the banking regulator, which is the price of accepting deposits and accessing the safety net. In exchange it must hold minimum capital and liquidity, lend prudently, and comply with rules on anti-money-laundering, consumer protection and disclosure. Unlike a public authority its mandate is simply to run a profitable, solvent business — but because its deposits are insured and its failure can threaten the system, it is bound by prudential rules that treat it as a regulated utility as much as a private firm.
Incentives
A bank profits by taking on more risk and more leverage, yet its own capital cushions only a thin slice of its balance sheet, so its owners enjoy the upside while deposit insurance and the central-bank backstop socialise part of the downside. This asymmetry tempts banks toward aggressive lending in good times and abrupt retreat in bad ones, amplifying the credit cycle. Competition for market share, quarterly earnings pressure and executive pay pull in the same risk-taking direction, which is precisely why capital, liquidity and supervision are imposed from outside to counterbalance them.
Powers & Instruments
- Accepting deposits repayable on demand.
- Extending loans and creating deposits in the process.
- Operating payment accounts, cards and transfers.
- Borrowing from the central bank against collateral.
- Issuing letters of credit, guarantees and other instruments.
Checks & Failure modes
Checks
- Capital and liquidity requirements set by the supervisor.
- On-site examinations, stress tests and reporting.
- Deposit insurance and lender-of-last-resort conditions.
- Market discipline from shareholders and bondholders.
Failure modes
- A bank run when depositors lose confidence at once.
- A credit bubble followed by a wave of loan losses.
- A liquidity crunch when short funding cannot be rolled over.
- Excessive maturity mismatch that a rate shock exposes.
- Contagion that spreads one bank's failure through the system.
Real examples
Key terms
- Maturity transformation
- Funding long-term loans with short-term deposits, the core of banking and its fragility.
- Fractional reserve
- Holding only a fraction of deposits as reserves and lending out the rest.
- Capital adequacy
- The requirement to hold enough own funds to absorb losses relative to risk-weighted assets.
- Net interest margin
- The spread between interest earned on loans and paid on deposits, the bank's core profit.
- Bank run
- A sudden mass withdrawal of deposits that can drain even a solvent bank of cash.
- Non-performing loan
- A loan on which the borrower has stopped paying, eroding the bank's capital.